On November 15, 2007, the Eleventh Circuit Court of Appeals – in The Estate of Jelke et al v. Commissioner – overturned the Tax Court and continued the steady drumbeat of judicial decisions allowing for a dollar-for-dollar reduction in fair market value for the hypothetical tax on trapped-in gains for a C Corporation shareholder. In reaching its decision, the Eleventh Circuit reviewed all of the prior trapped-in gains taxes in the various Circuits and noted that “this 100 percent approach settles the issue as a matter of law, and provides certainty that is typically missing in the valuation arena.” To better understand the ramifications of this decision, it is important to review that history of decisions leading up to Jelke.
In the 1935 Supreme Court case of General Utilities & Operating Co. v. Helvering, the court held that a C Corporation did not recognize taxable income at the corporate level on a distribution of appreciated property to its shareholders. Until 1986, the shareholders’ adjusted stepped-up basis in distributed corporate property was equivalent to the fair market value of that property.
The Tax Reform Act of 1986 made major changes to the tax law and enacted rules which required the recognition of corporate-level gains (and losses) on the distributions of appreciated property, thus repealing the doctrine set forth in General Utilities.
Concurrent with the repeal of the General Utilities doctrine, courts began to recognize that a discount to the fair market value of an asset should be allowed related to the corporate level capital gains tax triggered on liquidating sales and distributions of corporate property. However, the Commissioner did not immediately take this position and continued to adhere to his pre-1986 position that no capital gains discount was permitted on distributions of closely-held corporate stock.
From 1986 to 1998, taxpayers were unsuccessful in arguing for a discount for trapped-in capital gains due to the repeal of the General Utilities doctrine. For example, in The Estate of Ward v. Commissioner (1986), no discount for trapped-in gains tax was allowed as there was no evidence that liquidation was imminent or even contemplated. During this 12-year period, the courts steadfastly adhered to the position that the highly speculative nature of the tax mandated that its present value be zero and, therefore, no discount from fair market value be allowed. This rigid stance taken by the courts began to relax in the 1998 case of The Estate of Davis v. Commissioner.
In Davis, the Tax Court determined that a hypothetical buyer and seller would not have agreed on a stock price that failed to take into account the corporation’s trapped-in capital gains tax. Rather than allowing a separate deduction from value, the court concluded that a portion of the permitted discount for lack of marketability could be attributed to the trapped-in capital gains of the corporation’s stock.
Following on the Tax Court’s decision in Davis, the Second Circuit Court of Appeals in the case of The Estate of Eisenberg v. Commissioner (1998) vacated and remanded the Tax Court decision which disallowed a discount for trapped-in capital gains taxes. In doing so, the Second Circuit noted:
The issue is not what a hypothetical willing buyer plans to do with the property, but what considerations affect the fair market value of the property he considers buying. While prior to the Tax Reform Act of 1986 any buyer of a corporation’s stock could avoid potential built-in capital gains tax, there is simply no evidence to dispute that a hypothetical willing buyer today would likely pay less for the shares of a corporation because of a buyer’s inability to eliminate the contingent tax liability.
In Eisenberg, the Second Circuit became the first circuit court of appeals to directly address the implications of the revocation of the General Utilities doctrine.
Following these decisions, disputes between taxpayers and the Commissioner largely focused not on the recognition of a discount due to the existence of build-in capital gains, but rather on the magnitude of the discount to be taken.
In 2002, the Fifth Circuit went further in The Estate of Dunn v. Commissioner. In Dunn, the Fifth Circuit held that a hypothetical willing buyer-willing seller must always be assumed to immediately liquidate the corporation, triggering a tax on the built-in gains. By doing so, the Fifth Circuit held as a matter of law that as a threshold assumption, liquidation must always be assumed when calculating an asset under the net asset value of approach. In terms of the magnitude of the discount, the Fifth Circuit concluded that a discount equal to 100 percent of the capital gains liability on a dollar-for-dollar basis was appropriate.
This serves to bring us to Jelke, in which the Eleventh Circuit, relying on Dunn and others, overturned the Tax Court and allowed the estate a dollar-for-dollar reduction in fair market value for the built-in gains tax on C Corporation assets. In doing so, the court has continued its affirmation that such a dollar-for-dollar discount is appropriate when performing valuation for estate tax purposes.
David R. Bogus, ASA, CM&AA, is a Senior Manager in Ellin & Tucker, Chartered’s Business Valuation, Forensic, and Litigation Services Group.